Numerous statements have been made recently by Fed Governors saying they are actively looking at raising the Fed Funds rate soon. The most recent was a speech by Fed Chairwomen Janet Yellen stating that a March rate hike was highly likely if employment and inflation data continue to be in line with the central bank’s expectations. After putting a low probability on a Fed rate increase as recently as Monday, February 27th, investors now believe that a rate increase is highly likely at their March meeting.
Investors’ expectations have quickly been reflected in interest rates with the 10 year Treasury yield increasing from 2.36% at the end of February to over 2.50% a week into March. Looking back to when the Fed last raised the Fed Funds rate in December, the 10 year Treasury yield is actually slightly lower now even after investors have priced in a likely March rate hike. So while the Fed certainly has influence, there are many factors that impact interest rates.
We still very much recommend maintaining a fixed income allocation despite the head winds of a possible increase in interest rates. Fixed income should be viewed as an investment to maintain capital and provide stability from the more volatile equity side of the portfolio. On average stocks decline in value every four years while bonds fall six years. In addition, the declines from stock can be much more drastic than from fixed income. An increase in interest rates now is actually better for investors with a time horizon longer than the maturity of their bond portfolios as it will result in a higher expected return.
In order to cushion a fixed income portfolio from rising interest rates we recommend maintaining a shorter average maturity compared to the overall bond market. Shorter term bonds are less impacted by interest rates and have fallen less over the last six months. We also recommend diversifying amongst sectors. Corporate, government, mortgage and credit bonds react to changes in interest rates differently. By having exposure to all of these sectors it can limit the negative impact from rising rates. Finally, having exposure to foreign bonds can further diversify a portfolio. Foreign interest rates move differently than US rates providing exposure to multiple other yield curves. While rates in the US may rise other countries may see falling rates.
Regardless of the direction of interest rates over the coming years, we still believe they are a vital piece of a well diversified portfolio. By investing across sectors and globally and maintaining a shorter term allocation it can smooth out the ride and help you meet your long term investing goals.
|Index Performance||Feb.||YTD||Trl 1 Yr|
|US Stock (Russell 3000)||3.72%||5.67%||26.29%|
|Foreign Stock (FTSE AW ex US)||1.74%||5.22%||20.24%|
|Total US Bond Mkt. (BarCap Aggregate)||0.67%||0.87%||1.42%|
|Short US Gov. Bonds (BarCap Gov 1-5 Yr)||0.15%||0.34%||0.05%|
|Municipal Bonds (BarCap 1-10yr Muni)||0.66%||1.43%||0.01%|
|Cash (ML 3Month T-Bill)||0.04%||0.09%||0.39%|
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